National Veterinary Care Limited (ASX:NVL) is currently trading at a trailing P/E of 32x, which is higher than the industry average of 16.6x. While NVL might seem like a stock to avoid or sell if you own it, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for. See our latest analysis for NVL
Breaking down the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. By comparing a stock’s price per share to its earnings per share, we are able to see how much investors are paying for each dollar of the company’s earnings.
P/E Calculation for NVL
Price-Earnings Ratio = Price per share ÷ Earnings per share
NVL Price-Earnings Ratio = 2.71 ÷ 0.085 = 32x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as NVL, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 32x, NVL’s P/E is higher than its industry peers (16.6x). This implies that investors are overvaluing each dollar of NVL’s earnings. As such, our analysis shows that NVL represents an over-priced stock.
A few caveats
However, before you rush out to sell your NVL shares, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to NVL. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with NVL, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing NVL to are fairly valued by the market. If this is violated, NVL's P/E may be lower than its peers as they are actually expensive by investors.
What this means for you:
Are you a shareholder? If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to rebalance your portfolio and reduce your holdings in NVL. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.
Are you a potential investor? If you are considering investing in NVL, basing your decision on the PE metric at one point in time is certainly not sufficient. I recommend you do additional analysis by looking at its intrinsic valuation and using other relative valuation ratios like PEG or EV/EBITDA.